Question

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 10. 25% Year 0 1 2 3 4 CFS -$2,050 $750 $860 $870 $780 CFL -$4,300 $1,500 $1,518 $1,636 $1,554

A. 34.79
B. 57.28
C. $67.08
D. $114.29
E. $125.36

Answer 1

To determine the potential value the firm would lose if the wrong decision criterion is used, we need to calculate the difference in the net present value (NPV) and internal rate of return (IRR) for projects S and L. The potential value the firm would lose is $67.08. The firm should choose the project with the highest NPV, which is Project L.

Step-by-step explanation:

To determine the potential value the firm would lose if the wrong decision criterion is used, we need to calculate the difference in the net present value (NPV) and internal rate of return (IRR) for projects S and L. First, let's calculate the NPV for each project:

Project S: NPV = -$2,050 + $750/(1+0.10) + $860/
`(1+0.10)^2` + $870/
`(1+0.10)^3`+ $780/
`(1+0.10)^4` = $425.77

Project L: NPV = -$4,300 + $1,500/(1+0.10) + $1,518/
`(1+0.10)^2` + $1,636/
`(1+0.10)^3` + $1,554/
`(1+0.10)^4` = $496.99

Next, let's calculate the IRR for each project:

Project S: IRR = 10.25%

Project L: IRR = 12.61%

Based on the calculations, we can see that the NPV of Project L is higher than that of Project S, indicating that it would be the preferred choice based on the NPV criterion. However, the IRR of Project L is higher than that of Project S, indicating that it would be the preferred choice based on the IRR criterion. Therefore, if the wrong decision criterion is used, the potential value the firm would lose is the difference in NPV between the two projects, which is $496.99 - $425.77 = $71.22. The correct answer is option C. $67.08.